High Hopes and Blunt Truths for the $2.3 Billion Legal Marijuana Market

Like it or not, legal marijuana is here and the market is growing. Find out who stands to profit, what opportunities exist in this emerging market and what barriers these entrepreneurs have to overcome.

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Justin Hartfield knows weed. He founded his company Weedmaps, a
sort of Yelp for marijuana
dispensaries, in 2008, and now serves on the board of directors
for the National Cannabis Industry Association, the Marijuana
Policy Project and the National Organization for the Reform of
Marijuana Laws, which most people know as NORML and for which he
also serves as treasurer.

But before all that came his pot-shop epiphany, and before the
epiphany he was just a California dude with a brand-new medical
marijuana card burning a hole in his pocket.

Hartfield walked into his first dispensary in Los Angeles not
knowing his cannabis indica from his cannabis
sativa. He found himself confronting at least a dozen jars
full of different strains of weed. The sheer variety and
abundance blew his mind.

"Until then, I just thought marijuana was marijuana," he says
now, explaining how the shop employees dissected for him the
finer points of cannabis appreciation. "By the time I walked out,
I saw a business."

Weedmaps provides the menus and pricing of legal marijuana
dispensaries across the United States. Visitors can access the
site for free, while business owners pay a monthly fee to manage
their pages. Hartfield says the site is tracking half a million
products in real time, "not just strains but also edibles,
lotions, tinctures, salves, balms, clothing, bongs, vaporizers.
Anything a dispensary sells is on our weed menu." Weedmaps
brought in most of the $30 million in revenue that its parent
company, Ghost Group, which Hartfield also runs, earned last
year.

In early January 2014, the Weedmaps website had a special message
for visitors. "Congratulations, Colorado! Now you can find adult
use dispensaries near you," it said.

"Adult use" is the marijuana industry's preferred euphemism for
legal recreational use of cannabis, weed, pot -- call it what you
like. Marijuana became legal for recreational purchase and use in
Colorado on the first of this year, and adult-use facilities are
doing a booming business. Shop owners estimated that in their
first day they made more than $1 million in collective sales.

At Brooke Gehring's dispensary in Edgewater, Colo., a suburb of
Denver, 592 recreational customers showed up on Jan. 1. By
contrast, only four patients came in for medical weed that day.
Since then, more than 2,500 recreational users have come through
the doors, more customers than the shop had seen in the previous
two months combined. The average purchase was more than $100,
with taxes levied by the state included in the price.

Colorado has high hopes for legal marijuana. The state believes
the industry could rake in nearly $600 million in revenue this
year. That would mean $67 million in tax revenue for Colorado, of
which the first $20 million is earmarked for schools.

So far, the state's politicians appear to be pleased with the
rollout of recreational marijuana. "I want to thank the
businesses and consumers alike for acting responsibly and with
great accountability today," Denver's mayor, Michael Hancock,
said in a statement on Jan. 1. "Denver is a progressive city, a
vibrant city, and it's incumbent on all of us to continue getting
this right."

Right or not, legal marijuana is here, and it's a growing market.
Twenty-one states plus the U.S. capital allow medical marijuana,
and two states, Colorado and Washington, decriminalized marijuana
for recreational use in 2012. (Washington state's recreational
pot shops will open this summer.) Along with Washington, D.C., a
total of 15 states allow medical marijuana dispensaries.

A rising tide
This sea change on the state level reflects a rising tide of
enthusiasm for legal marijuana. According to Gallup, 58 percent
of people nationwide now say they support legalization. And they
are putting their money where their mouth is. The U.S. market for
legal marijuana, currently valued at $1.4 billion, is projected
to grow to $2.3 billion in 2014 and $10.2 billion in five years,
according to a recent report by ArcView Market Research.

In Colorado and Washington state, the combination of broad
popular support and potential for extra tax revenue, along with
promises to strictly regulate the industry, has convinced the
federal government to reserve judgment for the time being. That
is, the Obama Administration is willing to permit the adult-use
experiment for now, which means in some sense overlooking the
fact that marijuana is still, according to federal law, a
Schedule 1 narcotic with no known medical value.

It's politically risky for the federal government to ride
roughshod over state laws voted in by a majority of the people,
says William McGrath, a partner at the Washington, D.C.-based
Potomac Law Group. Political calculation also plays a role. "The
administration is fully aware of which way the wind is blowing on
the issue," McGrath says. "A majority of Americans favor
legalization, and there is overwhelming support among younger
voters."

In return, however, the Department of Justice has laid out strict
requirements that marijuana cultivators and retailers must
follow, and Colorado has issued rules of its own. Two documents,
totaling more than 230 pages and issued by the Marijuana
Enforcement Division, a branch of the Colorado Department of
Revenue, spell out the rules for medical and recreational
marijuana businesses.

"The oversight is extensive. This business is not for everyone,"
Gehring says. "We're in a highly regulated industry because of
the federal illegalities."

Barriers to entry
For would-be weed entrepreneurs, there are primarily three
barriers to entry. The first is the maze of legal requirements.
In Colorado, anyone directly involved in the production or
distribution of weed must have lived in the state for the past
two years, at a minimum. Retail shops and grow operations need
licenses, often multiple licenses, for which a public hearing and
inspections are mandatory. And like casino workers, Gehring's
employees have to be individually licensed by the state. Everyone
must pass a background check. And that's only the tip of the
iceberg. Even child-resistant packaging is required. "It's a very
comprehensive scheme that will require a great deal of expertise
that may be foreign to those in the marijuana trade," McGrath
says.

The second barrier is agricultural knowledge. All marijuana
retailers in Colorado are required to grow at least 70 percent of
the product they sell. Similarly, all growers are required to run
a dispensary. This so-called "vertical integration" requires
entrepreneurs to "marry a large-scale agricultural business to a
small retail location," says Gehring, who owns Patients Choice of
Colorado, a company which operates four dispensaries in the
state. "We have thousands of plants that are living organisms
that we have to maintain."

This looks set to change in October, when Colorado will allow
standalone cultivation and retail operations for the first time,
but until then it's the only way to run a legal pot business.
More onerous still, every single plant needs an RFID tag so that
it can be tracked "from seed to sale." Every weed shop in the
state is required to enter this data into the Marijuana Inventory
Tracking System, or MITS, which is overseen by the Marijuana
Enforcement Division. This is one of the most expensive
compliance requirements, Gehring says. In order to open her store
for adult-use sales on the first of January, she had to spend
$22,000 on tags alone.

Startup capital is the third barrier. What might at first appear
to be a small business in fact requires a multi-million-dollar
investment, Gehring says. Between her four dispensaries and her
35,000 square feet of production space, Gehring pays $115,000 in
annual licensing fees. She paid an additional $27,500 in
application fees so that three of her medical dispensaries could
start selling recreational pot. And then there are all the other
costs associated with running a business that grows a crop,
harvests it, packages it, transports it, stocks it and sells it
to customers at retail locations.

"This is not just like opening up a flower shop or a sandwich
shop," says Gehring. "The overhead just to operate, before you've
even built anything..." She falls silent, tallying the costs.

'A rounding error'
Proponents of legalization have long claimed that taking
marijuana out of the black market and putting it on store shelves
would lower prices and at the same time provide tax opportunities
for state and local governments. But Jeffrey Miron, a senior
lecturer in economics at Harvard University and a senior fellow
at the Cato Institute, is unimpressed with the projections. The
$67 million Colorado hopes to make in additional taxes is "a
rounding error" compared to the total state budget, he says. (For
fiscal year 2013, Colorado's budget was $20 billion.) "It's chump
change. It's nothing!"

"Of course it's not nothing," he corrects himself. "Yes, you can
fund a reasonable number of teachers, or firemen, or whatever
cutesy thing you want to use to make it seem important, but
spread out across the whole system it will not have a significant
impact."

What's more, the costs of setting up and running a new regulatory
compliance and enforcement division "will certainly cut into tax
revenues from marijuana sales," says McGrath of Potomac Law
Group. But he thinks the burgeoning industry will boost the state
economy in other ways. "Even if the revenue benefits to the state
aren't as much as expected, the industry will create new jobs and
bring money into the state as 'pot tourism' grows."

Meanwhile, however, consumer hopes for cheap weed, if they ever
existed, are being quietly dashed. Gehring's shop in Edgewater is
selling an eighth of an ounce for $55, which comes out to $64.90
with taxes. She has heard of retail prices as high as $75 pre-tax
for the same amount. In return, however, pot users get ostensibly
higher quality bud and more trustworthy, consistent suppliers.

Investment potential
Most banks remain wary of the weed business. Others would like to
lend a helping hand but find themselves stymied by federal law.
Jenifer Waller, senior vice president of the Colorado Bankers
Association,
told Reuters last November that several of her group members
"would be very anxious to bank the marijuana industry, but have
been told they cannot."

But in the absence of traditional finance, others are stepping
up. This week, High Times, the long-running magazine for
weed enthusiasts, announced that it was launching a
private-equity fund to invest in marijuana businesses. The HT
Growth Fund wants to raise $100 million over the next two years
for that purpose. It will invest primarily in businesses that,
while related to cannabis, are not directly involved in its
production or distribution, with investments ranging from $2
million to $5 million per company.

Individuals are also investing. Jeffrey Friedland is one of these
pioneers. He runs the financial services firm Friedland Global
Capital as well as a strategic advisory, Global Corporate
Strategies, that helps entrepreneurs gain access to foreign
capital. He considers legal marijuana an emerging market. He has
been making the rounds in Colorado, driving from one small
mountain town to the next, meeting with county and local
government officials and visiting the facilities in which he
hopes to take an ownership stake -- so far, two dispensaries and
their growing facilities. His involvement as an equity owner is
pending state regulatory approval.

To Friedland's experienced eye, the potential for profit is hard
to miss. At 9 p.m. on Jan. 8, he saw a line out the door of an
adult-use dispensary in the town of Breckenridge. "Stores running
out of supply short term is a real issue," he says. Prices are
high, but weed is still flying off the shelves.

"The first week of sales in Colorado has been a resounding
success from a business perspective," McGrath says. "But, because
the business is so highly regulated on a state level and the
threat of federal as well as state prosecution for violation
remains, potential investors will want to take a long, hard look
at the operations and the people involved in any investment
opportunity."

No more regulated than alcohol
Although it's now legal to buy, hold and smoke pot recreationally
in Colorado, it remains illegal to smoke it in public -- even
where lighting up a cigarette is okay -- or to drive a car while
high. It is also illegal to take pot purchased in Colorado across
state lines. And only licensed dispensaries may sell the drug.
Person-to-person selling is not allowed, nor is dealing to
customers under the age of 21.

"There's somehow this notion that we can legalize it and
eliminate the black market at the same time that we can control
it and keep it small," Miron says scornfully.

Anecdotal evidence suggests that increased access to the drug
leads to increased demand. It would be naïve to think that people
won't still attempt unlicensed grow operations in the hopes of
profiting from a cash crop. On Jan. 4, sheriffs in Kiowa County,
Colo. arrested two
people after discovering a house filled with more than 1,000
plants. The sheriff's office has reportedly asked the federal
Drug Enforcement Agency for help with the case.

It will take a lot for legal marijuana to win over law
enforcement officials. "The industry needs to prove itself to be
transparent, competent and dedicated to compliance with the
laws," McGrath says. "If that happens, and that experience is
replicated in other states, it would be difficult for a future
administration to kill the market."

Even so, Miron recommends caution. "It's still a long way from
actually being a legal product. There's all this extra silly
regulation that may keep the market a gray area, underground. So
while this is an important step because it brings attention to
the issue, because it shows that nothing catastrophic will happen
if you legalize marijuana, we're still a long way from the goal
line."

"At minimum, it should be no more regulated than alcohol," Miron
says. "No more than alcohol, tobacco, toaster ovens or Starbucks
coffee. It should just be legal, period."